ZK382 Royal Air Force Eurofighter Typhoon T3 takes off on a training exercise RAF Coningsby
The defense sector has been one of the worst hit by the pandemic this year, not least because of huge cuts to government spending. At the end of October, the sector’s average price-to-earnings ratio hit a 20-year relative low against the European market, according to JPMorgan.
But when Britain’s Conservative Prime Minister Boris Johnson announced the biggest defense investment since the end of the Cold War last month, sentiment on the sector started to turn.
Johnson has promised an extra £16.5 billion ($22 billion) in addition to the annual budget, which is almost £41.5 billion ($55.4 billion) for this financial year.
The announcement of the UK’s increased spending, combined with the outlook for Europe and the US, has fed into JPMorgan analysts’ positive view on the defense and aerospace sector.
As part of JPMorgan’s Europe and Global equity outlook released on November 30, equity analyst David Perry provides insight into the sector exploring the current state, the outlook for 2021 and a few key stock picks.
The UK, eurozone and the US play a key role in the sector’s outlook. This new report provides insight into how JP Morgan views all three markets.
The UK equity market has been upgraded to neutral, despite what analysts describe as the “worst performing equity region” this year.
“We continue to believe that FTSE250 is a better opportunity than FTSE100, and prefer UK domestic plays vs exporters. Overall though, while we expect the UK equity market to be higher next year, we do not think it will be outperforming eurozone, or global peers,” said JPMorgan equity analyst, Mislav Matejka.
The US has also been rated neutral, while the eurozone has been rated overweight.
“Eurozone tends to do better when value outperforms, while the US is heavily tilted towards quality/ growth style,” Matejka said. “We argued at the start of November that market participation would broaden into value, which should, in turn, support the better performance of eurozone versus the US.”
In addition to the UK’s decision on defense spending, political developments in three countries in particular have made JPMorgan more optimistic the sector:
1. France announced it would increase defense spending in 2021 by 4.5%.
2. Germany has awarded a number of major defence contacts.
3. The political gridlock in the United States with a Democratic White House and Republican Senate suggests major cuts to defence spending are unlikely.
Civil aerospace outlook
On the civil aerospace side, JPMorgan’s analysts are less optimistic.
The International Air Transport Association has said the global airline industry will incur materially bigger losses in 2020E and 2021E than ever before, this will have an impact on the civil aerospace industry, which provides hardware and software to the airlines.
Many investors are willing to look past 2020 and 2021 and toward a 2023 and 2024 recovery. But there are three reasons for investor caution looking ahead:
1. There is no guarantee that things will be back to normal in the space of a few years.
2. “Airlines have incurred huge debts in 2020-21, and perhaps beyond, and this makes it much harder for them to pay for maintenance and new aircraft,” Perry said.
3. Some civil aerospace companies burned billions of dollars in cash in 2020, which weakened their balance sheets.
Based on the positive outlook for the defense market and the more negative view on the civil aerospace sector, here are the analysts’ top two picks to buy and one to avoid at all costs:
Price target: £6.20
Potential upside (as of 11/30): 19%
Analyst commentary: “On November 12th BAE held a CMD is which it passionately argued that it expects several years of top line growth, some expansion of EBITA margins, and much improved cash conversion. The improved cash conversion is driven by lower pension deficit funding (largely over by 2022) and improved working capital practices.”
Source: JP Morgan Cazenove
2. Thales Thales stock on December 2
Price target: €91.00
Potential upside (as of 11/30): 14%
Analyst commentary: “Even if we look out to 2023E, we see that Thales is trading a major discount to French A&D companies like Airbus and Safran. Thales has a good mix of businesses: c50% of sales from defense provide stability (and some growth) and the other 50% of sales offer exposure to an improving economy post COVID-19. Management is confident that in the next three years it will deliver organic sales growth, improving EBITA margins and better cash conversion.”
Source: JP Morgan Cazenove
3. Rolls Royce Rolls Royce stock on December 2
Price target: £0.50
Potential downside (as of 11/30): -50%
Analyst commentary: “RR remains the weakest company in the European A&D sector. In Civil Aero it derives most of its sales from log haul international travel, the segment that will be the slowest to recover from COVID-19. Despite raising £2bn in new equity in 2020, RR still has the weakest balance sheet in the sector. It plans to raise a further £2bn from disposals in the coming year or so, but there is no guarantee of success here. We believe there is still a meaningful risk of another equity raise in the next 12-18 months.”
Source: JP Morgan Cazenove
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